DRI | ARE OLIVE GARDEN EXPECTATIONS TOO HIGH?

Darden Restaurants (DRI) remains on the Hedgeye Restaurants SHORT bench.

We like it when you can keep a thesis on a stock simple and straightforward! Expectations for a recovery at Olive Garden have gotten way ahead of reality.

DRI is going to report EPS in early December and the chances are high they have a good quarter. The current street estimate for Q2 ’15 is $0.42, up 50% YoY. Since November ’14 that estimate has moved up from $0.34, so expectations have increased 24% over the past 12 months. In addition, since Jan ’15 the estimate for FY ’16 has gone from $2.99 to $3.68, up 23%.

Over the last three quarters the company has beaten estimates by 18%, 16% and 18%, respectively. I suspect the company can beat the number but the days of the “big beat” and raise are over.

It’s been a year since Chairman Jeff Smith and his team took over Darden and what a year it’s been. Consider the following improvements to the P&L:

Consolidated SSS have gone from flat to nearly 3% growth

SSS for the OG have gone from 0.5% to 2.7% in 1Q16

LTM Food Costs have improved 56 bps

LTM Labor Costs have improved 34bps

LTM Other Expenses have improve 95bps

LTM Restaurant Margins up 186bps

LTM G&A has improved 81bps

LTM Operating Margins have improved 310bps

EPS has nearly doubled to $3.17 over the last four quarters

Management has executed a strong recovery in financial performance over the past 12 months. As you can see most of the gains have come from below the line cost cutting items, which are one time in nature. Importantly, the company has announced and filed the relevant docs to create a new real estate company. I understand there is an arbitrage that creates value by putting the OG rents in a vehicle, but what’s left is also very important.

As of 1Q16 this is what management is doing to post sustainable same-store sales growth at OG:

Value Proposition - “Olive Garden is where people of all ages gather to enjoy the abundance of great Italian food and wine, and to be treated like family”

Leveraging Core Brand Equities – Breadstick nation and Tour of Italy

Table top tablets

Refresh 19 restaurant with 25 more planned for 2016

As you can see there is not an abundance of new innovation and management is not investing behind the brand or the assets! As you can see from the chart below street expectation call for a significant acceleration is 2-year sales trends at Olive Garden. As we see it the slope of the red line is way too steep given there is little investment in the OG brand and the industry trends are slowing.

Given the current overall industry is slowing down, is it possible the trends at Olive Garden are that good? We don’t think it is logical to think that in 6 months Olive garden will be doing a 2.2% same-store sales on a 2-year basis.

Olive garden is the engine of growth for DRI. Olive Garden represents 56% of sales for the company we believe accounts for roughly 42% of the total value of the company after parsing out the REIT. Where Olive Garden goes, Darden goes.

Multi-concept casual dining restaurant companies struggle for the simple fact that it is difficult to allocate capital correctly. OG needs a lot of capital to reassert itself in the market while you have growth engines like Capital Grille and Yard House that need it in order to grow. The simple fact is Olive Garden is not getting the attention/capital it needs in order to return to meaningful long-term growth. This thinking coupled with a slowing casual dining industry is not good news for Olive Garden and the other concepts at Darden.

VALUATION

In a slowing sales environment with compressing casual dining multiples, if DRI were to trade at one of its closest competitors multiple, EAT, there is downside to the low $40’s.

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